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Investing may be considered more of an art than a science. Amidst a wide range of investment options, products may be selected basis individual risk profiles, financial goals and investment horizons. Within an investment portfolio, the focus should also be on diversification and optimal asset allocation.
Diversification of investment portfolio across different asset classes
It is always advised not to keep all one’s eggs in a single basket. The simple logic is that if something happens to the basket, all the eggs will be irretrievably broken. Instead, if one keeps the eggs in two or more different baskets, the risk of all the eggs being broken simultaneously is reduced to a large extent.
This analogy may be applied while investing in different asset classes. One may opt to maintain a diversified investment portfolio across various asset classes. This is because different asset classes may react differently to similar macroeconomic events.
For example, a tax subsidy announced to boost manufacturing may be favourable for equity markets. However, since it adds a fiscal burden to the exchequer leading to higher borrowings, it may not be favourable for debt markets. An investment portfolio diversified across different asset classes helps the investors mitigate the investment risk and benefit from investment cycles in various asset classes happening at different times.
Asset allocation may be considered the key to financial prosperity
While diversification across different asset classes is crucial, the asset allocation amongst these asset classes is essential too. Maintaining a balanced portfolio (best suited to individual risk appetite) may help leverage the respective risk-reward trade- offs of different asset classes.
Further, the suitability of a particular investment product is also contingent on the individual's investment horizon. For example, suppose the investment horizon is short- term. In that case, debt funds having a low to short duration are usually considered prudent investment options. This is because debt securities at near-to-short segments of the yield curve (up to 1 year) exhibit relatively lower volatility when compared with equities. However, for long-term investments, equities or debt funds having medium to long duration (3-5 years) are considered more suitable considering their wealth creation or income generation potential over the long term.
The short-term volatility of equities gets moderated over a long-term horizon. Since financial plans usually comprise different financial goals maturing in different time horizons, one may benefit from a balanced investment portfolio.
What is optimal asset allocation for a balanced portfolio?
There is no “one size fits all” investment strategy for a balanced portfolio, and the optimal asset allocation depends upon the investor's risk profile. When investors are young and may have fewer financial liabilities + more time in hand to achieve their financial goals, they may opt to have an investment portfolio primarily dominated by equities.
However, as investors grow older, some of the equity investments may be moved into debt to preserve the unrealized gains in the portfolio and further lower the portfolio volatility. Further, some investors may be comfortable with intermittent volatility in the portfolio but expect higher returns. They may consider higher allocations in equities than debt.
Similarly, investors who are content with lower returns, if offered with lesser portfolio volatility, may consider having an investment portfolio with a higher allocation towards debt.
Asset allocation – One-time process or a continuous process?
This is another myth revolving around asset allocation strategies that one needs to consider the asset allocation between different asset classes only at the time of investment. However, one must note that asset allocation is a continuous process, and investors must periodically rebalance their investment portfolios with the desired asset allocation.
Apart from the investment performance of different asset classes, asset allocation may need a change if there is a change in risk appetite, financial goals, or investment horizon. Usually, as time passes, the risk appetite may also steadily shift from aggressive to conservative.
One may keep the asset allocation aligned with such changes. A balanced investment portfolio results from the periodic rebalancing of the asset allocation within the portfolio.
Portfolio rebalancing
One may periodically review the investment portfolio to identify underperforming schemes and further check if the portfolio has continued to be balanced. Suppose the asset allocation has shifted from the optimal allocation target. In that case, one must rebalance the portfolio by increasing the allocations towards the asset class having lower allocation in the investment portfolio compared with the targeted asset allocation.
Maintaining a balanced investment portfolio is the key to prudent financial planning and ensuring a pleasant investment journey.
Disclaimer:
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